How To Become A Smart Seller Part I: Classics

Classic: Become a Smarter Seller, Part 1

The following was published at RealMoney, but I don’t know the date.

“I can always find good stocks to buy, but figuring out when to sell is harder.” (My Mom, when I was much younger.)

In some ways, my career in investing has been a happy accident. Much of my career has been in the insurance industry, working as an actuary. Being a generalist, with a focus on investments, this helped me to learn a great deal about institutional investing, before doing it myself.

At Provident Mutual, now a part of Nationwide Financial Services [NFS], I was the one financial analyst on a committee that chose the managers for a series of multiple manager funds for our pension clients. I ended up interviewing 30-40 top money managers over a three-year period. The similarities and differences were interesting. Two areas that we would always ask about would be their buy and sell disciplines.

On buy disciplines, the answers varied considerably. But sell disciplines were usually pretty similar, falling into three groups:

Price target met

Failure of momentum

Fundamentals deteriorate

The last of these is squishy, and I would usually ask, “How can you detect fundamentals deteriorating ahead of everyone else?” This would usually elicit the intelligent equivalent of a mumble.

There were a few of the better managers who used what I later called “The Economic Sell Rule.” The economic sell rule says that if a manager finds an asset that he likes better than one that he presently holds, he should swap. That means the manager either intuitively knows what he likes better, or estimates the anticipated rate of return (adjusted for risk tolerance) over the time horizon that he manages, to appraise the desirability of new assets.

I ended up calling it the economic sell rule, because each of three rules listed above had problems of their own. In a market where valuations are crazy, like the late 90s, many price targets get hit. If the manager is a “long only” manager, and has to stay fully invested, he can begin to run out of ideas on where to put money to work. For managers that can go both long and short, there is the problem that as price targets get hit on the long and short side in a sustained market rally, the portfolio gets shorter and shorter. And in a sustained decline, the portfolio gets longer and longer.

This is an implicit bet on mean-reversion, which no doubt happens, but often not soon enough for the clients of the manager, who can lose assets under management as underperformance persists.

Failure of momentum could take two forms: valuation-driven managers with price declines below original cost, and momentum-driven managers that would sell when relative strength weakened. Some valuation-driven managers would often sell any stock that declined more than a threshold percentage, whereas others would do a review at such times to check their investment thesis. After all, if a manager liked the company before, certainly he should like to buy it cheaper, no? Unfortunately, the pressure for instant results, measured on a monthly or quarterly basis, can force decisions that are less than fully rational.

As one manager said to me, “If it goes down more than 20% from where we bought it, we obviously didn’t get the story right, so we sell it and move on.” This is a recipe for turnover and underperformance. It is normal for stocks that are good long run performers to have 20% drawdowns once a year or so. Even with good research analysts, the odds of a 20% drawdown are decent, even immediately after a recommendation. In my own portfolio, after reviewing my thesis, I view 20% drops as buying opportunities.

Because I don’t manage money that way, I can’t comment as competently on the momentum-driven managers. I will only note that they have high turnover rates, and that their trading tends to demand liquidity, rather than supply it. In future articles, I will comment on the tendency for those who supply liquidity to be rewarded for it.

Though I never heard a good explanation for having a competitive edge in detecting deteriorating fundamentals, following the fundamentals is the most useful way for developing a sell discipline. Absent surprises, companies and industries perform better or worse as investors change their estimates. As the forward-looking estimate of future returns for a company falls below that of prospective purchase candidates, it is time to swap out. As the forward-looking estimate of future returns for a company rises compared to other companies in a manager’s portfolio, it is time to buy more.

Consider when a “surprise” happens to a company. Surprises can be positive (e.g., possible takeover, good earnings), or negative (e.g., bad earnings). After a surprise, is it time to sell, buy more, or wait? It boils down to how much the surprise affects the manager’s estimate of value for the stock. (And to some degree, how much it has affected the estimates of others.) How much has the long-run earning power been affected? For how much could the company be sold off?

Answering questions like these will lead to the estimates of value that can properly inform sell decisions in volatile times. Using a discipline like this forces a manager to re-estimate a forward-looking estimate of return, rather than let greed or regret drive decision-making.

In my next article, I will show how this process has worked in practice for me, together with another technique that some managers use to pick up some incremental return, and reduce risk.

Author: David MerkelDavid J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately.
From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies.
Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.
From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that.
Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.
My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog.
I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.